While there has been plenty of talk about the inflated state of Australia’s residential property market, there has not been much discussion, at least in public, of what would happen if property prices were to collapse. While the outcome of lower house prices is open for debate, some investors are playing it careful. Aberdeen Asset Management’s head of Australian fixed income stated it had cut back holdings of bonds issued by Australian banks. However, he said Aberdeen now holds covered bonds as well as mortgage-backed securities issued by those same banks.
Covered bonds are almost the same as normal “vanilla” bonds except they have an additional security in the form of a claim against a particular pool of assets of the issuer. Normally bonds are unsecured and should the issuers become insolvent, investors have a claim on the issuer’s assets after secured creditors. Covered bond holders are first in line and, as such, the yield on these bonds is lower than a yield on a normal bond by the same issuer.
Mortgage-backed securities (MBS) are, as the name suggests, securities backed by a pool of mortgages. Some mortgages in the pool may actually turn bad but the idea behind MBS is the pool is diversified enough so any losses are already factored in as part of the yield. MBS were at the heart of the 2007/2008 financial crisis which started in the U.S. because borrowers’ circumstances turned out to be highly correlated and therefore a pool of these MBS were not really diversified at all. In the case of Australian MBS, borrowers cannot simply walk away from their mortgages; the loans are full-recourse whereas in the U.S., mortgages were, and are, mostly non-recourse. Thus, risks to investors is lower than if the MBS comprised U.S. mortgages.
The fact Aberdeen favours bonds and securities linked to particular assets instead of ordinary bonds says something of Aberdeen’s concerns regarding risks posed by Australian banks and their exposure to the Australian housing market. Publicly Aberdeen says Australian banks are in good shape and they could handle some problems in the property market. However, the asset manager’s actions suggest it is not entirely convinced and it has hedged its bets. The possibility of some unknown, unforeseen outcome in the Australian housing market flowing through to Australian banks has pushed Aberdeen and possibly others to reduce exposures to these banks. Whether this action represents unjustified fears or prudent planning will be seen in the months and years to come.